Five Nightmare Scenarios: What Can Go Wrong with Business Succession in Estate Planning
BY PATRICK M. KLEMZ, ESQ.
IN THE FINAL SEASON OF the HBO series Succession, family drama ensues when someone finds an undated will signed by conservative news mogul and patriarch Logan Roy, naming his son Kendall as the CEO upon Logan’s death. Obviously, this is fantasy. Dated or undated, a will has no direct legal bearing on who has the authority to run a corporation. While probate could shift the balance of stock ownership in time, nothing would change immediately. The owners of the controlling interest directly, or indirectly through a board of directors, appoint the new manager of the business.
The mundane truth is that public corporations have comprehensively documented succession plans and procedures, leaving no room for HBO-style drama, and closely held businesses often have no plan at all. This is backwards. Managing owners of a closely held business have more reason, not less, to plan for their own demise and incapacity because the ownership base, like the shareholders in a public corporation, may not be organized or informed enough to act.
Below are five business disasters that can unfold when the manager of a closely held business dies having failed to plan for their succession.
Five Nightmare Scenarios: What Can Go Wrong with Business Succession in
Estate Planning
BY PATRICK M. KLEMZ, ESQ.
IN THE FINAL SEASON OF the HBO series Succession, family drama ensues when someone finds an undated will signed by conservative news mogul and patriarch Logan Roy, naming his son Kendall as the CEO upon Logan’s death. Obviously, this is fantasy. Dated or undated, a will has no direct legal bearing on who has the authority to run a corporation. While probate could shift the balance of stock ownership in time, nothing would change immediately. The owners of the controlling interest directly, or indirectly through a board of directors, appoint the new manager of the business.
The mundane truth is that public corporations have comprehensively documented succession plans and procedures, leaving no room for HBO-style drama, and closely held businesses often have no plan at all. This is backwards. Managing owners of a closely held business have more reason, not less, to plan for their own demise and incapacity because the ownership base, like the shareholders in a public corporation, may not be organized or informed enough to act.
Below are five business disasters that can unfold when the manager of a closely held business dies having failed to plan for their succession.
THE HERMIT ENTREPRENEUR
Sadly, this is the most common scenario with single member limited liability companies or S corporations managed by a single member-manager or shareholderofficer. That person did not store records in an organized fashion or may not have kept management records at all. After they die, the heirs find statements for the operating account and possibly investment accounts holding the capital reserves. Then, one of the heirs, having been appointed personal representative (PR) by the court, goes to the bank with the letters of administration, believing they can transfer the funds to the estate account to pay the mortgage and taxes on the house left to the heirs.
Yet, what does the bank say? That the PR does not have authority granted by the corporation or LLC to transact with the bank. Only the hermit holds that authority according to the bank’s records. The heirs then decide to authorize one amongst them
Managing owners of a closely held business have more reason, not less, to plan for their own demise and incapacity because the ownership base, like the shareholders in a public corporation, may not be organized or informed enough to act.
THE MOGUL’S SHAM
When a prospective client calls with an estate for a small business owner born before World War II, a worrisome scenario emerges. It typically goes like this: The mogul sets up a business and it is wildly successful, so he sets up another and another. By the time of the mogul’s death, he is the operator of five or six similar businesses, perhaps established in different states. During his lifetime, the mogul treated the operating accounts of the business as his personal property and commingled funds. The mogul signed licensing or profit-sharing agreements between the multiple businesses and signed the deals on behalf of both. The mogul issued salaries to himself or family members with no regard for the value of the services furnished (if any).
This type of self-serving behavior was par for the course with businessmen of older generations. Today, courts label businesses operated in such a manner as shams and may allow creditors to reach the owner’s personal assets. Corporations and other limited liability entities protect the private assets of the owners, but only if those assets are separately held and managed with fairness and fidelity to the entity. In truth, a lot of bad behavior by a manager can be remedied while the manager is still in the picture. However, if the mogul dies unexpectedly, their PR may have to contend with aggressive creditors or an upset family member who received a piece of one of the businesses long ago.
UNFINISHED BUSINESS
to serve as the new bank signatory, pursuant to the business’s organizational documents. But where are the organizational documents? On file with the state? Which state? The state where the hermit died? The state where the hermit lived in 1977? Delaware or Wyoming because of their favorable laws? Florida because that is where the hermit planned to retire? The heirs must spend time and money to bring the chaos under control. The hermit entrepreneur could have handed his heirs a successful business, but, because of poor record keeping and organization, they instead inherited a headache.
Imagine a construction firm doing asbestos removal on a college campus over the summer when the owner passes away. The banks freeze the firm’s operating accounts until a new officer can be appointed, which cannot happen until the PR receives letters of administration from the court. Suddenly it is late August. The school wants to open the building, but it looks like a mess and might even be too dangerous for occupants. The PR might not be able to step in even if they possessed the training and knowledge to do so. For example, the banks typically will not accept the court’s letters of administration as adequate authorization to add the PR as the signatory to the business operating account. Often, they want a new banking resolution, as mentioned above. If the PR cannot write checks or direct deposits, she cannot borrow money or collect on accounts receivable, cannot pay employees or subcontractors, cannot purchase bonds, supplies, or materiel. The PR is stuck.
The following is a true practice anecdote documented in lengthy federal court proceedings. An American arms contractor executed a large contract with a foreign sovereign in late 2004. The foreign sovereign refused to make payments required under the contract, so the owner went driving through a war zone to demand the payment of funds. En route, somebody shot up his car, killing the owner and one of his employees. (Draw your own conclusion about who ordered the hit—nobody has ever been
charged in the murders, but one Iraqi official was convicted in absentia for corruption relating to the same arms contract). The business tried to carry on, but ultimately failed to complete the contract. Nobody else could really get the foreign sovereign to release the capital needed to move forward and both sides claimed breach of contract. 20 years later, the matter is still not fully resolved.
THE SETTLING OF OLD SCORES
Sibling rivalries account for most probate disputes and business partners make for the worst “frenemies.” For example, picture three brothers who never liked each other, but inherited the family business because the patriarch of the family had illusions about them working well together. The oldest brother dies without a will and his shares go to his two children under the Maryland intestacy rules. The youngest brother then dies with a will that names his wife as PR and leaves her everything. Now she is stuck with 1/3 of the stock and cannot exercise any control under the bylaws. The surviving middle brother hated the younger brother because he got equal interest in the business from their father, even though he was never involved in the business except in board matters, and refuses to give his widow anything but the most basic information about the affairs of the business. Meanwhile, the children of the oldest brother, happy to remain passive investors and traveling abroad, cannot be bothered to attend a shareholder meeting.
So what can the wife do? Does she sue her brother-in-law to make him buy out her interest in the company? Does she continue to trust someone who hated her dead husband to do right by her in distributing the business’s income going forward? And, even before all that, how does she tell the probate court how much the stock is worth when her brotherin-law will not furnish her with information except the bare minimum guaranteed to minority shareholders. She is stuck because her husband did not account for the pettiness of his older brother before he died.
THE OFFICIOUS INTERMEDDLER
Elder exploitation, sadly, happens all the time. Both the District of Columbia and Maryland have robust laws to prevent elder exploitation that are easy to apply when the elderly person has clearly become incapacitated or their free will negated by pressure or subtle coercion— the legal doctrine of “undue influence.” But more typically that is not the case. Perhaps the elderly person just really likes their younger partner. They know they have more money than they can easily spend in their remaining lifetime, so why not have a little help spending it?
The most important resources to assess in business succession planning are the people already involved.
The business succession problem arises in this scenario when the elderly person loses the ability to run a complex business operation and their dubious partner steps in to take over, which never goes well. The values of the officious intermeddler might not match those of the organization. The partners or family members may not like the officious intermeddler to begin with because of their own judgments about the appropriateness of the relationship. This type of situation can easily be avoided if the owner realizes ahead of time that dying at his desk is not a realistic plan. If they do not select a successor and properly prepare the successor before losing the ability to lead, an unprepared successor might run the business into ruin.
Conclusion
Most would agree that spending a lifetime to build a business only for it to fall apart soon after your death makes no sense. Unfortunately, a business that has value as a going concern can lose that value very quickly through the mismanagement of successors. Sometimes the best option is to sell the majority interest to a proven manager who then will keep generating income for the heirs and minority shareholders. Or an independent trustee of the stock can keep a family successor manager from making everyone in the family a victim of their bad business sense. Or perhaps the best choice is to divide up the enterprise and leave each heir responsible for their own success or failure (although this did not work out well for Alexander the Great or Charlemagne).
In truth, no universal answer avails itself. The only sound course for the owner is to recognize that their leadership will eventually fail, which is often the hardest step, and to make a plan that takes full stock of the available resources. The most important resources to assess in business succession planning are the people already involved. Knowing what they can and cannot do will likely make the difference between carrying on a successful legacy or creating a business succession nightmare.
M. Klemz, Esq. is an estates and trusts and business attorney with the Rockville, Maryland law firm Miller, Miller & Canby.
Patrick
